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Kleptocracy and Tax Evasion Under Resource Abundance

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Kleptocracy and Tax Evasion Under Resource Abundance Received: 20 June 2018 | Revised: 10 January 2019 | Accepted: 24 January 2019 DOI: 10.1111/ecpo.12130 ORIGINAL ARTICLE Kleptocracy and tax evasion under resource abundance Hamid Mohtadi1,2 | Michael L. Ross3 | Uchechukwu Jarrett4 | Stefan Ruediger5 1University of Wisconsin, Milwaukee, Wisconsin Abstract 2University of Minnesota, Minneapolis, Evidence has shown that petroleum wealth is associated Minnesota with less transparency and at the same time less tax collec- 3 UCLA, Los Angeles, California tion. In this paper, we find that the two issues are linked 4 University of Nebraska, Lincoln, Nebraska through the citizens’ tax evasion behavior. We develop a 5 Arizona State University, Tempe, Arizona model to explain this link and conduct extensive empirical Correspondence tests of its validity. The explanation is that officials tradeoff Hamid Mohtadi, University of Wisconsin, greater transparency to improve tax compliance against less Milwaukee, WI. transparency to increase gains from corruption. Oil wind- Email: [email protected] falls diminish tax revenue needs, causing officials to opti- Funding information mize on less transparency. Seeing this, citizens optimize on Economic Research Forum a lower level of tax compliance. At equilibrium, both de- cline with a positive oil shock. We also study the alternative channel in which tax compliance responds to enforcement. Transparency is found to be the more robust channel. Ignoring citizens’ strategic behavior would lead to predict- ing suboptimal investment in state capacity for tax enforce- ment. Using giant oil discoveries data combined with oil price data, we develop a dynamic composite instrument and estimate the model with a dynamic panel system general- ized method of moments. We find robust support for our explanation and the model's deep structure for 130+ coun- tries and the 1980–2010 period. JEL CLASSIFICATION Q34, H3, H26, O17, O11 Economics & Politics. 2019;1–51. wileyonlinelibrary.com/journal/ecpo © 2019 John Wiley & Sons Ltd | 1 2 | MOHTADI ET AL. KEYWORDS corruption, oil, public policy, resource curse, tax evasion, taxation, transparency 1 | INTRODUCTION Does a kleptocratic state produce less compliant citizenry? This paper provides a framework to answer this question with reference to a kleptocratic state's tax policy and its citizen tax evasion behavior, both in general and under natural resource abundance. Natural resource wealth is linked to a range of ad- verse economic and political outcomes.1 Focusing on the state's capacity to collect taxes, and adopting the fiscal capacity framework of Besley and Persson (2009) and Cárdenas, Ramírez, and Tuzemen (2011) show that natural resource dependence reduces the state's capacity to collect taxes. When Besley and Persson (2010, 2011) introduced natural resources in their framework, they too predict that natural resource dependence leads to weaker state capacity. Crivelli and Gupta (2014) found evidence of resource revenues having a negative effect on income taxes, while Jensen (2011) suggested that “resource intensification weakens state- building by impeding the state's fiscal capacity.”2 The approach taken in these papers implicitly assumes that citizens automatically increase com- pliance in response to greater tax enforcement as a part of the state's investments in capacity. This implies a more or less passive citizenry and overlooks their active participation in a tax evasion game. Ignoring citizens’ strategic behavior may predict suboptimal investment in state capacity for tax en- forcement when agents’ (citizens’) behavior is not anticipated. Critically, tax compliance may respond to other factors in addition to enforcement, such as the transparency of state policy. Overlooking this issue will lead to a second suboptimality of investments in state capacity for tax enforcement. We show that optimal level of enforcement (when it exists) depends on how much transparency is provided and find that (under some mild conditions) more transparency means less enforcement is needed. Specifically, we analyze a game in which tax payers comply/evade optimally, given the state's enforcement and transparency policies. In turn, the state chooses its policies, anticipating the tax pay- ers’ optimal compliance/avoidance response. Although this aspect of the model, i.e., the interaction between transparency and tax enforcement, is general and independent of natural resource wealth, the focus on resource rich economies brings in an additional dimension to consider. Specifically, resource windfalls diminish tax revenue needs and this causes corrupt officials to optimize on less transparency and less enforcement, and citizens to “optimally” comply less. Empirically, we find that (a) oil wealth does reduce both transparency and tax enforcement (or its proxy) and consequently the level of citizen tax compliance; and (b) that transparency is a more robust substitute for tax enforcement even in the presence of oil wealth. In short, the model and its deep structure is supported by extensive empirical evidence. For oil wealth, we use exogenous oil discoveries and for method, we use a dynamic gen- eralized method of moments (GMM) technique that addresses endogeneities. In effect, we show that natural resource abundance alters, not only the nature of institutions but the behavior of the citizens. Interestingly, tax evasion/tax compliance is discussed primarily in the taxation literature and mostly for developed economies (Andreoni, Erard, & Feinstein, 1998; Cuccia, 1994; Jackson & Milliron, 1For summaries of this voluminous literature, see Frankel (2010), Ross (1999, 2015), Stevens and Dietsche (2008) and Wick and Bulte (2009). 2Juan Pardinas, the General Director of the Mexican Institute for Competitiveness stated in 2013 that, “We collect few taxes because we have oil… That allows us to pay less in taxes…” (New York Times, September 9, 2013). MOHTADI ET AL. | 3 1986; Kinsey, 1986; Long & Swingen, 1991; Richardson & Sawyer, 2001) and, at any rate, almost never in the context of a natural resource windfall. Transparency matters. It allows the tax payers to observe how public funds are spent. Without such observation, tax payers lose trust which increases their incentive to evade taxes. In addition, because rentier states prefer less transparency to hide extraction of resource rents for personal use, more re- source rent implies even more rentier behavior, providing the tax payers with added incentive to evade. Petroleum wealth is indeed associated with reduced transparency, meaning fewer public disclosures about government policies, institutions, and activities,3,4 as shown in Figure 1. We explore why re- source wealth reduces transparency. Figure 2 also confirms the negative association of oil wealth with tax revenues. We employ several rich datasets. First, we exploit plausibly exogenous cross- country variations on new giant oil field discoveries (e.g., Arezki, Ramey, & Sheng, 2017) complied by Horn (2014), combining it with exogenous temporal variations from oil prices to construct a composite dynamic in- strument for oil. We also use high quality data on taxation, meticulously complied by the International Center for Tax and Development (ICTD, 2014), and oil values complied by Ross (2013) both of which remedy shortcomings of other alternatives as detailed in the data section, along with datasets on transparency and accountability by Williams (2011, 2015). With the aid of this and other data, the deep structure of the model and its implications are tested for the period 1980–2010 and for 130–150 countries using a dynamic panel system GMM approach. Results strongly support the model and its implications. This paper is related to several strands of the literature. First, its key channel besides enforce- ment, i.e., the link between tax compliance and government transparency, is inspired by the FIGURE 1 Oil and transparencySource: authors 3A prevailing definition of transparency used by the International Monetary Fund (2012) is: “the clarity, reliability, frequency, timeliness, and relevance of public reporting and the openness to the public of the government's fiscal policy-making process.” 4Several international initiatives are based on the belief that this outcome is not inevitable. They include the Extractive Industries Transparency Initiative, the IMF's Fiscal Transparency Code, the UNDP's Strategy for Supporting Sustainable and Equitable Management of the Extractive Industries, and the mandatory disclosure laws adopted by the US and EU for extractive industry firms operating abroad. 4 | MOHTADI ET AL. FIGURE 2 Oil and taxation taxation- representation arguments in which the government's need for direct taxation induced greater political accountability both in the nineteenth century Europe (Hoffman & Norberg, 1994; North, 1990; North & Weingast, 1989) and in contemporary societies (Brautigam, Fjeldstad, & Moore, 2008; McGuirk, 2010; Ross, 2004). Viewed in this perspective, the paper examines whether the presence of large oil revenues may compromise this historical social contract and, if so, the way in which this happens. Second, this paper is also related to the literature on the effect of natural resources on institutions. Several papers find that the “economic resource curse”, i.e., the adverse effect of natural resources on growth, operates only conditionally, i.e., only if institutions are weak to begin with.5 More recent work suggests that institutions are themselves affected by resource dependence. This paper is related to
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